Rolling with the Punches

RYO/MYO sales bruised, but not battered.

Last year’s passage of the State Children’s Health Insurance Program (SCHIP) spelled grim news for the previously barely taxed roll-your-own-tobacco segment.

Many experts and even some suppliers feared the segment’s doom once federal taxes soared from $1 per pound to nearly $25. Bloggers took to their keyboards, with one announcing “the government has now taxed RYO out of existence.” Tom Briant, executive director of the National Association of Tobacco Outlets, was simply dumbfounded: “We were not ready for what they did to RYO.” Nearly a year later, the segment, though stung, still lives. It continues to innovate, market and pursue its niche within the broader tobacco category, which remains the convenience channel’s most popular destination.

“Many retailers believed the RYO/MYO sales would evaporate due to the tax increases, and that’s just not the case,” says Steve Sandman, vice president of sales and marketing for Glenview, Ill.-based Republic Tobacco L.P., makers of Top, Gambler, Drum and Job. “We’ve seen this model in Europe, including the false marketing of RYO/MYO as pipe tobacco, and at the end of the day our products will still continue to sell and grow over the long term. The smart retailers have expanded the RYO/MYO category and have seen great results, as they can see the longterm success of the category.”

Last April’s SCHIP arrival brought two immediate threats to RYO suppliers and primary retailers. First was the stifling tax that upped per-pound prices to $24.78. Second was the floor tax that prompted retailers to dump product, curb inventory and reset their tobacco plan-o-grams, cutting space from niches and harder-to-sells.

According to data from Nielsen, pre- SCHIP numbers from Dec. 26, 2008, indicate that RYO/MYO sold 38.5 million units, while numbers from the same time period in 2009 show unit sales down by 5 million to 33.4 million. This would seem to indicate that SCHIP and other regulatory factors account for roughly 5 million fewer units sold in 2009. However, largely due to higher fees, RYO dollar sales for the same time period jumped from almost $101 million in 2008 to $135 million last year.

The challenges of RYO do not end with SCHIP. Arguably more threatening in the long term is empowerment of the U.S. Food and Drug Administration (FDA) to regulate the entire tobacco segment, from ingredients to marketing restrictions.

THE NEW NORMAL

When SCHIP first took effect, uncertainty ruled the day. High levels of product returns to manufacturers from retailers and wholesalers who didn’t want to pay the initial floor tax, and the discounting of RYO tobacco at retail and wholesale alike prior to the effective date of the tax, distorted how trade channels appeared directly after the increase went into effect.

“In essence, trade channels had little RYO cigarette tobacco in stock, and retailers did not start to reorder product until consumers started asking for branded products in the store,” says Ron Tully, vice president of new projects and initiatives for Louisville, Ky.-based National Tobacco, via an e-mail interview. “Once the trade channel started to fill up again, manufacturers started to get a better picture of RYO demand.”

And while the FDA is now part of the new normal, suppliers expect the agency to create some confusion for some time.

“FDA regulation,” says Republic’s Sandman, “has been and will continue to be time-consuming and demanding. The industry is continuing to look for guidance from the FDA, and continues to wait for clear direction as court cases and interpretations are issued on an ongoing basis.”

For instance, the FDA’s new Center for Tobacco Products, which provides oversight of the tobacco industry, banned the sale of cigarettes with flavors characterizing fruit, candy or clove. Also included under that ban are flavored loose and roll-your-own tobacco, as well as cigarette rolling papers and filters that contain a characterizing flavor.

But, all that said, manufacturers and retailers of RYO are hanging in there. In fact, some RYO products are gaining share. According to Sandman, the company’s premium TubeCut by Gambler is “experiencing tremendous growth and consumer acceptance.” Nielsen statistics from the 52 weeks ending Dec. 26, 2009, show the .65-ounce bags of Gambler went from 104,991 units in 2008 to 193,352 in 2009.

“[SCHIP] drove people toward quality,” says Josh Kesselman, director for Phoenix-based HBI International, which manufactures Juicy, Elements and Raw rolling papers, among others. “It came to the point that, because of taxes, a Hyundai and a Mercedes cost about the same. So what are you going to buy?

“Because the price differential, percentage- wise, is no longer that great between low-end tobacco and high-end tobacco, we’ve witnessed … an increase in high-end [RYO] tobacco. Now, when you’re smoking a high-end tobacco, the thing is, you usually don’t want to use a cheap paper. So that has caused an increase in our sales of premium rollyour- own paper.”

To back his point, data from UBS Securities tobacco analyst Nik Modi supports that within the RYO segment— much like cigarettes—middle of the road is losing out to both pre-mium and bargain brands. Data shows that as state excise taxes go up, price gaps narrow. This correlation encourages an increase in premium market share as smokers opt to either trade up or trade down to the deep-discount segment (CSP—Jan. ’09, p. 57).

DEFINING RYO

The federal government’s foray into RYO is causing some huff-and-puff among suppliers, specifically around what exactly is roll-your-own tobacco.

HBI filed a federal lawsuit to overturn the FDA’s ban on flavored cigarette rolling papers. In the lawsuit, the company argues that the FDA bans flavored cigarettes and other associated parts of the flavored cigarette such as the tobacco, paper and filter, but it does not mention that the ban would include flavored cigarette rolling papers that are packaged separately, such as HBI brands Juicy Jays and Skunk. That lawsuit is still pending.

“We sued them, and they claimed that their posting on their Web site was ‘not binding’ and that they had not made a final decision yet,” Kesselman says. “This put flavored rolling papers into purgatory while we continue to try and work things out with the FDA.” Likewise, there has been some internal squabble concerning what counts as RYO vs. pipe tobacco—part of a broader concern about segment blurring within tobacco.

According to Jim Colucci, executive vice president of sales and marketing for Altadis USA, when RYO got hammered initially, some products shifted categories to pipe tobacco. Thus, they can be used for RYO without facing the RYO levy. “Pipe tobacco is the new king of RYO,” with sales increasing fivefold, he said at the recent CSP Convenience Retailing University conference.

On its Web site, the Alcohol and Tobacco Tax Trade Bureau (TTB), a division of the U.S. Treasury department, acknowledges some confusion on this matter: “Currently, no regulatory standard exists to differentiate between the two products other than the statutory definitions. … We are currently evaluating methods to differentiate between the two products and foresee providing specific guidance in this regard in the near future,” the site says.

“In the meantime, the packaging and labeling of the products in question will have particular significance. For example, TTB will consider the extent to which the packaging and labeling for a pipe tobacco product clearly presents the product to the consumer as such and not as roll-your-own tobacco, or whether there are representations or implications on the package or in other materials which tend to contradict the stated tax declaration.”

Of course, that means savvy suppliers can potentially position certain RYO product as pipe tobacco. With that, Colucci coyly points out, “I prefer a new definition than paying a $24-per-pound tax.” (See sidebar on p. 104.)

GROWTH OUTLOOK

Despite SCHIP and FDA hurdles, outlook is good among manufacturers. Refocusing on certain brands has helped, despite the fact that many have completely eliminated all one-pound bags of MYO, because the tax increase has put these products out of reach for many customers due to the large outof- pocket expense.

“We have experienced tremendous growth and consumer acceptance of TubeCut by Gambler,” says Sandman of Republic. “Sales are strong and consumers love the product, and this continues to grow in all sizes and flavors. We expect this trend to continue.”

For HBI, it’s all about quality. “It’s like the middle of the market is dead,” Kesselman says. “It drove people in one of two directions. It drove them either to premium or dirt cheap. Standard stuff is dead or dying. … We’ve seen our sales of premium go up and our sales of lowend rolling papers go up.” Innovation is also key. To keep up with changing consumer preference, many manufacturers are coming out with new, innovative products that are revitalizing the category.

At HBI, premium hemp and rice papers are outselling its lower-tier items, and ramped-up packaging to stress the premium qualities of a rolling paper are also beginning to have a role. For HBI, the best strategy would be if retailers stocked the very lowest and highest ends of the brand spectrum. “We have a twopronged approach,” Kesselman says. “[Stock] super-cheap papers such as the Laramie 89-cent, 1 ¼ papers coupled with specialty papers such as RAW and Elements that can capture both sides of the market. Why leave cash on the table?”

Convenience stores are notorious for offering little RYO selection, hampered in most part by limited space. There is also an issue of freshness: If product sits around on the shelf too long, it can dry out. Industry experts say this issue can be solved by educating c-store staff; the product can be rehumidified. But the profits should outweigh the issues.

“The c-store industry could maximize the category much better if they are nimble and quick to respond,” Sandman says. “There’s lots of business out there for RYO/MYO with better margins than premade cigarettes, and because these stores have space constraints, they need to remove products that aren’t selling and replace them quickly with ones that do.” _ —Mitch Morrison contributed to this story

Raising the Roof on Pipe Tobacco

Certainly, the current economic environment has been a challenge for MYO manufacturers, but not for obvious reasons. According to Steve Sandman, vice president of sales and marketing for Glenview, Ill.-based Republic Tobacco L.P., many small manufacturers that were all but nonexistent a year ago have been manufacturing MYO tobacco and packing it into bags labeled pipe tobacco, which, for now, has a considerably lower FET tax burden. The result has been renewed attention by the FDA on pipe tobacco, and how to more appropriately tax the product. “Unfortunately, many retailers that have purchased products from these companies may find it difficult or impossible to return merchandise that consumers no longer want to purchase,” Sandman says.

A bill was introduced to Congress in January that would increase the federal pipe-tobacco tax from $2.83 per pound to $24.78 per pound. The new bill, H.R. 4439, would amend federal law to make the tax rate on pipe tobacco equal to the rate of RYO/MYO tobacco.

Statistics show that the amount of pipe tobacco produced in the month of April 2009 more than doubled, increasing from an average of 270,000 pounds per month to more than 566,000 pounds, according to NATO.

And as of August 2009, the Alcohol and Tobacco Tax Trade Bureau, a division of the U.S. Treasury department, reported that 1.7 million pounds of pipe tobacco were produced compared with 660,000 pounds of RYO tobacco. This makes the category very popular among proponents of raising the taxes. Reports indicate that the U.S. Treasury may be losing as much as $32 million due to the shift in the amount of pipe tobacco produced and the current tax status.